Shadow banking—the intricate web of financial arrangements and techniques that developed symbiotically with the traditional, regulated banking system over the past 30 or so years—is territory Gorton has studied for decades, but it (and he) have been largely on the periphery of mainstream economics and policy.

That all changed in mid-2007, when panic broke out in the subprime mortgage market and financial institutions that support it. Expressions like “collateralized debt obligation” and “repo haircut” escaped the confines of Wall Street and business schools, and began to fill the airwaves. We’re still struggling to come to terms—and few are in a better position to help than Gorton.

Gary Gorton: The term shadow banking has acquired a pejorative connotation, and I’m not sure that’s really deserved. So let me provide some context for banking in general.

Banking evolves, and it evolves because the economy changes. There’s innovation and growth, and shadow banking is only the latest natural development of banking. It happened over a 30-year period. It’s part of a number of other changes in the economy. And let me give even a little more context, historical context. I want to convince you that shadow banking is not a new phenomenon, in a sense—that we have had previous “shadow banking” systems in the past—and that there is an important structure to bank debt that makes it vulnerable to panic. So, the crisis is not a special, one-time event, but something that has been repeated throughout U.S. history.

Before the Civil War, banking involved issuing private money—that is, banks issued their own currency or bank notes. And this system worked in the way economists would expect it to work. The private bank money did not trade at par when it circulated any significant distance from the issuing bank. Instead, it was subject to a discount, so that a bank note issued by a New Haven bank as a $10 note might only be worth $9.50 at a store in New York City, for example.

Such discounts from par reflected the risk that the issuing bank might not have the $10—redeemable in gold or silver coins—by the time the holder took the note back to New Haven from New York. The discounts from par were established in local markets. But you can see the problem of trying to buy your lunch when the cook has to figure out the discount. It was simply hard to buy and sell things in such a world.

A big innovation in that period was to back the money by collateral, by state bonds. It turned out that this didn’t always work very well because the bonds themselves were risky. The National Banking Act then corrects this by having the government take over money and issue greenbacks, or federal government notes backed by Treasuries. That was the first time in American history that money traded at par. That was 1863.

The National Banking Acts (there were two of them) are arguably the most important legislation in the financial sector in U.S. history. But what’s interesting, and the reason I bring this up, is that as that was going on, a shadow banking sector was developing. And this shadow banking sector first really makes itself felt in the Panic of 1857 when depositors run and demand currency from their checking accounts.

So, after the Civil War, there’s no problem with currency [because greenbacks were backed by the federal government], but we have this other form of bank money: checking accounts—which appears to be shadow banking.

It develops into something very large and repeatedly has crises. In the late 19th century, academics were literally writing articles with titles like “Are Checks Money?” in top economics journals. And in 1910, the National Monetary Commission, which is the precursor to the Federal Reserve System, commissions 30-some books, one of which is about the extent to which checks are used as currency for transactions. So they’re still studying it in 1910.

Eventually, as you know, we get deposit insurance, which then makes checks safe, so to speak. (…)

In the last 30 or 40 years, there have been a number of fundamental changes in our economy. One of the most fundamental of these has been the rise of institutional investing. The amount of money under management of institutional investors has just been exponentially increasing. These include pension funds, mutual funds, large money managers. And these institutions basically have a need for a checking account, if you will. So if you’re a large institutional money manager, you may need a place to put $200 million, and you want it to earn interest and to be safe and accessible. That led to the metamorphosis of a very old security: the sale and repurchase (or “repo”) market. Like a check, repo had been around for perhaps 100 years, but it was never very large.